The Greatest Consumer Story, Issues Aside

Andy Rothman has lived and worked in China for almost 20 years, first as a US Foreign Service officer, then as a China macro strategist at brokerage and investment firm CLSA, and, since 2014, investment strategist at investment management firm Matthews Asia, which invests largely in consumer-facing companies in China. In addition to his core duties analyzing China’s economy and political environment, he writes the Sinology letter, which sums up the tides of China’s macro environment for the general reader.

Despite the periodic ferocity of China bears in recent years, who seem to perennially warn of China’s imminent economic collapse, Rothman has taken a more positive and nuanced stance on the country’s prospects—in particular the growing strength of its consumers. While acknowledging the great challenges facing China’s economy at present, Rothman maintains that China has the world’s “greatest consumer story,” and that it will pave the way toward the future. In this interview, he discusses both, and tells us why all investors, not just those with China investments, should pay close attention to the world’s second-largest economy.

Q. In your Sinology letter for Matthews Asia, you often refer to China as having the greatest consumer story—what makes it so good?

A. It’s a combination of factors. Maybe the most important one is that income in China has risen at an incredible pace in recent years. Over the last decade, real income adjusted for inflation in urban China has gone up by 120%. You can compare that to an 11% increase during that same period of time in the US, or about 2% in the UK. So that arms Chinese consumers with the cash to spend. There’s also lower household debt.

Another important factor is that Chinese are pretty optimistic about their futures. If you look for example at polling from the Pew Global Attitudes survey, they ask Chinese people do you think your kids will be better off financially than you are? More than 80% of them say yes. Contrast that with the last time Pew asked that question in the United States and only 30% of Americans said yes.

Q. It is also true that Chinese consumers are still on the whole less wealthy than Western consumers. That does mean there is more room to grow, but even given the optimism on the part of Chinese consumers, how much can we count on that? What kinds of questions should we ask ourselves on the negative side?

A. While I am very optimistic about the consumer story in China, I also want to be realistic. Almost every part of the Chinese economy, for every year, on average, for the foreseeable future, is going to grow just a little bit more slowly on a year-on-year basis. So we need to be realistic in the sense that over the next ten years, real income growth is not going to be 130%, but the base has gotten very big, so the incremental expansion is still huge. We need to be realistic that retail sales growth, which a few years ago adjusted for inflation was running at 11% and now is just under 10%, is going to continue to decelerate. If we are investors looking at companies that sell cars or shampoo to the Chinese, we need to be realistic that growth in sales revenue is not going to be as fast in a few years as it was in 2016.

Now that said, one thing that people forget about is the base effect. For example last year China’s GDP growth was just under 7%, ten years earlier it was about 13%, so that’s significantly slower [than it was]. But those numbers are multiplied on a base, and the base for last year was 270% bigger than the base ten years ago, which means that the incremental expansion in the size of China’s economy last year at a much slower growth rate was still 70% bigger than it was at the faster growth rate ten years ago, and so a better opportunity to sell goods and services to Chinese people because the size of the expansion was bigger and there were better opportunities to invest in those companies.

This is why I’m always pained when the media tends to frame each quarter’s GDP growth as “this quarter was the slowest since the Tang Dynasty.” It’s going to be growing more slowly on average each quarter for many, many years until it stabilizes at two or three percent growth like we are happy to experience in developed economies.

Q. You write for an investor audience that is very savvy, but China is very complex, and on top of that you have to contend with mainstream media, which, as you said, can get hung up on things like headline GDP numbers. So what are the challenges you face in just communicating what is happening in China?

A.One of the biggest problems that I face now is that I feel the media in its coverage of China is often looking for the most dramatic, most sexy story. And so as a result, they highlight real, significant problems in China… But my concern is that it seems that each time a problem is discussed, it is in conjunction with the expectation that that problem is going to cause a crisis or a hard landing sometime in the very near future. This has been a pattern for well over a decade now, and China yet continues to survive these problems and muddle through—growth rates are slower, volatility is higher.

One of the key arguments that I am making to our investors, or potential investors, is that China does face a long list of problems, but what is important to figure out is: What are going to be the consequences of these problems? Are the consequences going to be collapse, crisis, flames and locusts, or is it going to be more like what we have seen over the last ten years, which is every year a little bit slower growth, a little bit more volatility, but still one of the fastest growing economies in the world? Last year China accounted for 35% of global economic growth, a larger share of global economic growth than the US, Europe and Japan combined. And that’s despite the imminent predictions of impending doom.

Q. One of the issues that you have downplayed, which is huge in the media, is debt levels in China, the reason being that the vast bulk of it is state debt. Why does that make such a big difference in the situation and how we should view it as a risk?

A.I think it is really important to recognize that the debt problem in China, unlike in the US in the last decade, is a corporate debt problem rather than a household debt problem—that makes it a lot easier to deal with. And then within the corporate sphere the debt levels are extremely high, but it’s also important that they are primarily a problem for state-owned companies, and to recognize that the origin of China’s debt problems was the state directing state-controlled banks to lend money to state-controlled companies to build state-directed public infrastructure. And my view is that whenever I don’t see that included in the discussion of the debt problem, I feel that the writer doesn’t really understand the differences between China’s debt problem and debt problems in the US or European countries. That’s not to say that it isn’t a problem, but because there is no private participation, there’s no equivalent of a Lehman Brothers. The Chinese government has the luxury that the US government didn’t have of deciding when and how to deal with the debt problem, because you can’t envision a Chinese state-run bank taking a Chinese state-run company to bankruptcy court, unless the state agreed. And that gives the Chinese government the ability to schedule resolutions, which I think they started doing.

Another important factor is that because all the banks are controlled by the state, there is no question of the kind of issues that amplified the problems in the United States, which is that many financial institutions lost confidence in each other and refused to do business with each other. That’s not going to happen in an economy in which every significant financial institution is controlled by the state. So my view is that the debt problem is real, it is significant, but it is more likely to contribute to steadily slowing growth and more volatility and weaker bank profits than it is to contribute to a Western-style financial crisis, because China doesn’t have Western-style banks.

Q. Earlier in the year you said that capital flight is maybe over. But in the wake of the US election and the strengthening dollar, that problem has returned. How long do you think the new episode of capital flight will last?

A.Let me answer that by saying I don’t think the phrase “capital flight” applies to China, I prefer to talk about capital outflows. The reason for that, and I think it is an important distinction, is for me capital flight is about Chinese people losing faith in their economy, in their government, and selling their assets whether it is real estate or businesses and trying to get all their cash out of the country. I don’t think there’s evidence that that’s happening. To me, what we are seeing is a combination of other factors driving money out of China. At the beginning of 2016, in January and February, the newspapers and TV were full of people arguing that by the end of 2016 China wouldn’t have any foreign exchange reserves, and as a result of trying to defend against that, the RMB would devalue by 25% or 30% against the dollar. Well, by the end of the year China still had more than three trillion in US dollars in foreign exchange reserves, and the RMB devalued by about 6% against the dollar. So neither of those big scare stories happened, and the reason for that is that we didn’t really see capital flight. Instead what we saw was a big jump in outbound investment by Chinese companies, an amount that increased by about 40% year-over-year. And if you add it all up that is about equal to two-thirds of the reduction in China’s foreign exchange reserves, and so I think that’s been one of the biggest contributors.

Other factors are involved as well. China has clearly spent some of its reserves defending the currency, but another issue is valuation. About 40% of China’s reserves are held in currencies other than the dollar, and as a result of the strong dollar, those reserves lost value, and that contributed to the reduction in foreign exchange reserves. But it’s also important to note that the speed of the outflows, after the beginning of 2016 was actually much slower. Now, I think there is going to be a lot of anxiety about this issue again. We haven’t heard from a lot of the people that were hyping this issue in January and February 2016 in a long time, but I think they will be back very soon. In January, China’s foreign exchange reserves dipped below $3 trillion US dollars, and while some have hyped this as a critical tipping point, to me it is an interesting number, but it is not really meaningful. You have to remember that countries are not setting out to have as much reserves as possible, they are setting out to have appropriate levels of reserves, and China has way more foreign exchange reserves than it needs by any metric. So this is a gradual reduction in reserves—and keep in mind Japan has the next largest stock of reserves after China, and it is only about one trillion US dollars. So I think this is going to generate a lot of anxiety for a couple of months, like it did at the beginning of 2016, but only until people realize that it is not a big story.

Q. One issue that does make some people nervous is the slowdown that is happening in private investment in China. The reason is that it seems to be a good indicator of faith in the economic future of China by domestic companies doing business here. What is behind that slowdown?

A. I agree that’s an important question, and I am concerned about it as well. I’m also concerned that I can’t explain it in a way that I feel comfortable with.

I think one of the big structural changes in the Chinese economy that many people are unaware of is this shift from an entirely state-driven economy, to one that’s primarily driven by small entrepreneurial firms, just like in the West. When I started working in China several decades ago there were no private companies at all. Today more than 80% of employment and all of the new job creation in China, and certainly all of the wealth creation, is coming from these small private firms. So that’s the most important part of the Chinese economy. If those firms are not investing in the future then we should be concerned about that. And up until the beginning of 2016, for several years, every month the growth rate of investment by privately owned firms was faster than that by state-owned firms. Private firms still make up the majority of investment, but they have been cutting back lately. Nobody is really exactly sure what is happening here.

Some people argue that this is in fact an inaccurate picture created by a change in the data collection and data presentation by China’s National Bureau of Statistics. According to the NBS, however, there is not a data problem of this nature. Although some people are skeptical, I tend to believe them because this is an issue that they would rather not have to deal with, so if they could explain it away as a data problem, you would think that they would.

Possibly the explanation is that private firms are nervous about future prospects and are therefore holding on to their retained earnings rather than reinvesting in their businesses. Manufacturing overcapacity is certainly a factor. But I have to say that this is an unclear issue right now, and we have to watch this carefully and see how it plays out, because if private companies that generate all the new jobs in China don’t invest in their futures then there will be a serious issue.

Q. There are big changes also happening in foreign direct investment (FDI) in China, and part of that I see is natural—the sectors you want to invest in do of course change. How should foreign investors approach these changes?

A. First, as someone who is following the Chinese economy, the slowdown in foreign direct investment in China doesn’t worry me very much because FDI has always been a very small share of total investment in China. And in fact I would argue that the biggest impact of FDI in China has not been related to the number of dollars that have been put in, but instead the impact of those dollars in terms of bringing in modern manufacturing processes, HR, marketing, product development, and things like that. Another point to consider is that one of the reasons that FDI appears to have slowed down is that it has become mature, and that there is so much foreign business investment already in China that I think a lot of the new investment is coming from the money that has been earned in China, and so it is not counted as foreign direct investment.

But there are also new and troubling barriers that the government has put in place, or is talking about putting in place, but that’s more of a commercial dispute issue between governments, rather than something that worries me a lot in assessing the health of the Chinese economy. I hope that the Chinese government will realize that one of the reasons that the Chinese population has become very wealthy over the past couple of decades is by being very open, and that reversing that would be detrimental to China’s future.

Q. How do those big, government-driven changes, affect the way that Matthews Asia invests in China?

A. That doesn’t really have much of an impact on us. We look at China as a domestic demand story. And this is aligned with what we talked about earlier as my view of China as being the world’s best consumer story. So we tend to invest in Chinese companies that are producing goods and services to sell to Chinese people, and so the issues about foreign direct investment don’t really have an impact in the way we invest.

Of our China investments, about 87% are in what I would call “domestic demand” stories—Chinese companies producing goods and services to sell to Chinese people. So that should be pretty well insulated from any disputes over FDI, or even any disputes that might arise under the Trump administration between China and the United States—that part of the story should hold up really well.

I think one of the changes that has taken place for investors in general is that it has become a lot harder to invest in the China growth story via multinationals, in part because there aren’t that many multinationals who derive enough share of their revenue and revenue growth from China to make it a China play. And also in part because of government restrictions on foreign firms. But a bigger part of it is that Chinese companies have just become very, very competitive in recent years, especially in the consumer and services space. And so we are looking primarily at Chinese firms there.

Q. What are your thoughts on the Chinese economy looking ahead?

A.I have three broad comments. First, to reiterate why I think it’s important for businesses and investors to pay attention to China, is that in recent years China has accounted for about one-third of global growth. So even if you never own a Chinese stock, you really need to understand what is happening in China, and I feel that a lot of the media coverage right now is biased toward saying that all the problems, which although real and significant, will result in an imminent collapse. But the story tends to be a little bit more boring than that. These problems are real, but are more likely to contribute to slower growth and more volatility, and understanding that is important.

The second point I would make is that 2017 is shaping up to be a volatile year for China, based on what Donald Trump suggested he might do. We’re talking about currency manipulation, we are talking about raising tariffs on imports from China, or we’re talking about ripping up the One China Policy, which has been in place since 1972. In the coming months we’ll have a better idea, but my assumption now is that Donald Trump will listen to US CEOs, listen to the retired generals, and realize that having an antagonistic and confrontational relationship with China is not in the best interests of the United States, and that while there will be a lot of anxiety in the first half of the year, I think by the summer there will hopefully be more confidence that the relationship will continue as it has been for the last several decades, with recognition that there is mutual self-interest in a stable relationship.

Finally, even if there is increased tension in the US-China relationship, China’s domestic demand story should remain very healthy.

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